untangle the complex

Month: June 2015

India’s finance minster Arun Jaitley recently said that retrospective tax is a closed issue. This is a much needed relief for FPI’s. Of late Indian markets have corrected on news of Minimum Alternate Tax (MAT) demand by tax officials arising from gains made by foreign investors in stock markets. Some foreign portfolio investors (FPI) have taken legal remedy. This Government versus FPI tussle on MAT might take long to resolve and can be a major overhang for Indian markets.

What is the issue all about?

It all started with the income-tax department sending tax notices amounting to Rs 602 crore to 68 FPI’s seeking MAT on gains made in stocks. Media estimated MAT demand by tax officials from FPI’s ranging between Rs 7,000 crore to Rs 40,000 crore. While Government thought the tax demand was legitimate, FPI’s have contested that they are not required to pay MAT.

But, what is MAT?

A company can lower its tax liability using various exemptions.Besides exemptions, there are several deductions permitted. Companies in the past used to show profits, pay dividends to investors, but due to tax planning paid little or no tax to the government. This was hurting government’s revenue.MAT is a way of making companies pay a minimum amount of tax.

How is it calculated?

In order to make companies pay taxes, MAT was introduced from assessment year 1997-98. If company’s tax liability after tax planning is less than the threshold 18.5% then the company needs to pay a MAT at the rate of 20%. MAT is applicable on the profits as shown in the financial statements. Payers of MAT are eligible for tax credit, which can be carried forward for 10 years and set off against tax payable under normal provisions.

So, what is the confusion?

It was thought that MAT was applicable to only Indian companies and not foreign companies. However, a ruling in 2012 by a tax bodyheld that MAT provisions will be applicable to foreign companies also. Based on this ruling the tax authorities send notices to FPIs demanding MAT.

What are FPI saying?

Foreign investors are of the view that MAT is applicable only to Indian companies and not on foreign companies or investors. FIIsoperate in the form of a trust and partnership and MAT provisions may not apply to them. Otherkey argument is that MAT can be levied only on book profits as maintained in books of accounts. But, for FPI’s there is no such requirement to maintain books of accounts.FII income is considered capital gains and subject to capital gains tax.

What is the IT department saying?

Apart from relying on the above mentioned ruling in 2012, IT department contests that many FPIs are structured in India as companies. So FPIs having business presence in India are required to pay MAT. However, FPIs based out countries like Mauritius and Singapore, with whom India has double taxation treaties, are completely excluded from this scrutiny.

Why are FPI’s spooked?

Union Budget FY16 has stated that FPIs will not be liable to pay MAT on capital gains arising on or after April 1, 2015. However, the current IT notices pertain to previous years.

What has the government conveyed?

Government has communicated that MAT will not be applicable to FPIs based out of tax haven like Singapore and Mauritius. More than 30 per cent of investments by foreign institutional investors come from such treaty countries.Further, MAT will not be applicable prospectively from 2015 onwards as per the Union Budget. But, the finance minister has gone on record that the ministry would not intervene in cases before 2015 and FPIs are free to contest the dispute the appropriate courts. On May 8, Government forwarded the MAT dispute with FPIs to a committee headed by Law Commission chairman A.P. Shah and sought an early recommendation.

Why the controversy is bad for the markets?

IT department can go back retrospectively for 7 years. So, all transactions from 2008 can be considered for scrutiny. Some FPIs have already gone for a legal remedy. The tussle can be a long drawn legal battle. This would be a major overhang for the markets. FII’s are major drivers with around 20% ownership in Indian stock markets. Unfavourable ruling from the higher courts in the tax disputes can mean slowdown in net flows from FPIs. With the current controversy even governments’ investor friendly image is also at stake.Till the time further clarity emerges on MAT FPI sentiment will likely remain muted.

Government of India has come out with draft guidelines of the gold monetisation scheme announced in the Union Budget FY16. Comments on the draft guidelines can be sent to the finance ministry by June 2. Post deliberations on the comments, Government will come out with its final guidelines and run the scheme at few places on a pilot basis.

What is the objective behind such a scheme?

There are three objectives of the schemes: 1) To mobilize idle gold held by households and institutions (temples) in the country. 2) To provide alternate source of gold from banks to the domestic gems and jewellery sector. 3) To reduce reliance on imported gold over time to meet the domestic demand.

What is the background to the scheme?

India is amongst the largest importers of gold. This has contributed significantly to trade imbalances. Current account deficit had reached 6% to GDP in 2013 due to surge in gold imports. Weak external sector also lead to a plunge in the Rupee. Further, affinity towards gold as an investment destination has reduced financial savings in the economy.

What is the scheme?

The scheme works like this: a minimum of 30 grams of gold in jewellery or bullion form is needed to participate. -A preliminary test will be conducted to estimate the amount of pure gold in the jewellery or gold bar. If the customer does not agree with the result, the jewellery will be returned to the customer. -If the customer gives his consent, the jewellery will be melted (in front of the customer) and the customer will be given a certificate of gold deposit, attesting the purity and amount of gold deposited. -Next, the bank will open a Gold Savings Account for the customer, and credit the amount of gold to the customer’s account. Both the interest and principal payment paid to the customer on this account will be valued in gold. For example, if you deposit 100 grams gold, you get 101 grams of gold at the end of year one. The bank will decide the interest you get on the gold deposit. -The tenure of the deposit will be of 1 year and with a roll out in multiples of one year. Like a fixed deposit, breaking of lock-in period will be allowed. – The purity testing centre will transfer the gold to refiners who will store the gold bars in warehouses (unless banks prefer to store it themselves).

So, how would the scheme help the economy?

The estimated stock of gold in India is anywhere between 18,000-20,000 tonnes. Analysts expect a reduction of CAD by 30basis points if the new scheme is able to mobilise even 1% (200 tonnes) of the gold stock. This will have a positive impact on the currency. If the scheme works as intended even gold smuggling will come down in India.

How do individual gold depositors benefit from the scheme?

Gold savings account will be exempt from capital gains tax, wealth tax and income tax. These along with interest rates offered by banks are incentives enough for individual gold depositors to participate in the scheme. Storing gold with the refiners under the scheme will also offer gold depositors a safe place to store gold.

How do banks tend to benefit?

Banks could benefit significantly from the new scheme since the mobilized gold will be considered as a part of CRR/SLR requirements. This will free up resources for banks to lend to other needy sectors.

How will the gems and jewellery sector benefit?

Availability of gold with the banking sector will increase post the positive roll-out of the scheme. This in turn will be made available to the gems and jewellery sector. Secondly, India being one of the largest players in the gold market, the scheme can put negative pressure on international gold prices, lowering the gold cost to the sector and thereby helping exports.

What are the challenges to the success of the scheme?

Gold mobilisation from households will be a major challenge. There are social and cultural reasons for holding gold in India. It remains to be seen if families or temples will be willing to exchange gold for cash or gold bars. Setting up infrastructure for testing gold will also be a challenge. The fees for testing gold and time involved throw their own set of challenges for proper roll-out of the scheme. Smooth roll-out to the scheme will also depend on the attractiveness of the interest rates offered by the banks to gold depositors.

Do we have a precedent to such a scheme?

Yes. There is an existing Gold Deposit Scheme (GDS) introduced in 1999 which is a failure. The new scheme tends to correct the flaws in the earlier scheme. The earlier scheme failed due to high ticket size (500 grams vs. 30 gram now) and longer tenure (3-7 years vs. 1 year now) of deposit. Even the incentives offered to the banks limited its success. Hopes are high that the new scheme will succeed.